A Home Equity Loan: Is it right for you? 2004 CBR. This document was produced by the CBR Foundation for Financial Education, Inc., in Racine, Wisconsin. CBR is a non-profit organization dedicated to providing financial education to the Racine community. You may make copies of this document in its entirety for distribution in the classroom, civic and community groups and the workplace as long as you give credit to the CBR Foundation for Financial Education, Inc. and make no changes to the content.
A Home Equity Loan: Is it right for you? If you own your home, it s probably your greatest asset. Be very careful about taking out a home equity loan. If you fall behind in the payments, you could lose your home. What is equity? Home equity is the difference between the balance of your loan and the market value of your home. So if you owe $50,000 on your home, but it s valued at $80,000, you have $30,000 in equity. You can borrow against this equity. In essence, you are using your home for collateral. This document has four sections: Section 1: Home equity loans: pros and cons. Why you might get a home equity loan: benefits and drawbacks. Section 2: Shop, shop, shop, and read the fine print. How to make a good decision on a loan based on the facts. Section 3: Look out for deceptive practices. Predatory and deceptive practices you might encounter, whether you re shopping for a home equity loan or not. Section 4: Protecting yourself against unscrupulous lenders. Good advice before signing on the dotted line. Section 1: Home equity loans: pros and cons First, let s define the difference between a home equity loan and a home equity line of credit. A home equity loan is closed-end credit. You get all your money up front and make fixed payments (usually) for a determined amount of time (the term) until the loan is paid off. A home equity line of credit is open-end credit. You re approved for a certain amount of money and you ll probably have a variable rate. You can take advances for various amounts of money up to your pre-established credit limit. You make payments (including interest) only when you have outstanding balances against your line of credit. The APR of each advance is determined by the agreement of your contract. Generally, with a variable rate loan, the rate is tied to an index 1 and can go as high as 17%. A home equity loan can be a great way to eliminate unsecured debt, pay for college tuition, buy a car, improve your home, and more. With current low rates on mortgage lending, home equity loans are a good deal right now and could improve your financial stability. Or, it can be a way to postpone the inevitable if you don t clean up your act. If you take a home equity loan to consolidate high interest debt, like credit cards, and don t change your spending habits, you ll end up worse off than ever. It all depends on the borrower. Having a home equity line of credit is handy to have during an emergency, and you only pay interest on the money you spend. By getting equity lines when things are going well, you ll have something to fall back on if you lose your job, if there is an extended illness or if there are other pressing emergency situations. Avoid frivolous purchases, however, such as a vacation or a big screen television. It ll cost you a lot more over the term of the loan, especially if you have it stretched out over 10- to 20-year terms. If you buy a television for $3,200 today on your equity line and stretch out the payments for 10 years at 5.4%, you will have paid $4,148 for your television. And will it still be working? Reserve your home equity loan spending for major purchases and items that are likely to last for years. 1 index - a table of yields or interest rates that is used to determine interest-rate changes for adjustable-rate mortgages and other variable-rate loans such as home equity loans and credit card debt. Page 2 of 8
125s. Some lenders are willing to finance as much as 125% of your home s actual market value. This is called a 125 and is defined as a high loan-to-value home equity loan. Look at this example of how the dollars play out. Value of home $100,000 Amount still owing -$80,000 Amount of equity $20,000 Value of home $100,000 125% of your home value $125,000 $125,000 - $80,000 = $45,000 Amount of home equity loan $45,000 Total amount of indebtedness $125,000 What happens if you fall behind on your loan? Not only could you lose your home, but you would also owe any or all of the $25,000 that you have not paid back. So ask yourself carefully: 1. Do I really need a home equity loan? 2. Can I afford to take on more debt? 3. Do I really know what my monthly obligations are? 4. Will I be able to make the additional monthly payment? And finally, and most importantly, if you re using a home equity loan to consolidate and replace high interest debts, such as credit card debt: 5. Do I have the discipline to change my spending habits and not run up those high interest cards again? You may have a lot of equity built up in your home, but you will be taking on more debt. You need to be very familiar with your monthly obligations. If you can t make the monthly payments, you may find yourself in a very difficult situation: You could lose your home. If you still think you can afford it, read on to find out how to shop for a loan. Section 2: Shop, shop, shop and read the fine print Variations on the home equity loan Q: Is the rate fixed or variable? A: A fixed rate loan is one in which the APR (annual percentage rate) is set and doesn t change over the life of the loan. This is usually for a closed-end home equity loan. A variable rate loan is usually for a home equity line of credit. The APR is tied to an index and varies over the life of the loan. If interest rates fall, then your APR might be lower. The opposite is true if rates go up. Q: What does it mean if there is a balloon payment on the loan? A: Sometimes the terms of a loan include a balloon payment after a certain period of time, usually two or three years. At that time you will have the option to refinance or pay off the balance of the loan. You might want a balloon payment after a certain period of time, for example, if you know you plan to sell your home. Sometimes the lender requires it if your credit rating is low. Page 3 of 8
Q: How long can I take to pay it back? A: Home equity loan terms vary; 5-, 10- to 15-year loans are the most common. Depending on your needs, this is something you and your lender will discuss. Obviously, the longer you take to pay it back, the lower your payments will be. However, the longer the term, the greater the amount of interest you ll pay over the life of the loan. And, generally, the interest rate for longer terms is higher. Imagine that you want to borrow $10,000 to make some home improvements. Look at the comparison below of a loan for $10,000 for terms of 5 years and 10 years. Loan Amount: $10,000.00 $10,000.00 Annual Interest Rate: 5.40% 5.95% Length of Loan (in Years): 5 10 Number of Payments Per Year: 12 12 Total Number of Periods: 60 120 Payment Per Period: $190.55 $110.77 Total Interest Paid: $1,433.02 $3,292.35 Total Payments: $11,433.02 $13,292.35 Q: What is a home equity line of credit? A: Instead of borrowing a fixed amount for a fixed period of time at a fixed rate, a home equity line of credit allows you to pay interest only on what you borrow. If you have a line of credit of $10,000 and spend $4,000 to landscape your yard, you ll only pay interest on that amount. You will have $6,000 remaining on which you can borrow and as you pay down the television, your available credit increases. In that sense, it works much like a credit card, except the interest is lower and it varies depending on the interest rate currently in effect. Your lender will set a time limit when no future advances will be allowed and payments will simply be applied to all outstanding debt. Compare rates, points and fees A loan that looks like a good deal because of a low interest rate could have higher closing costs, fees and points. It s always a good idea to get at least two proposals so you have a comparison. It is also recommended that you shop with a financial institution that you re familiar with, perhaps the one that has your mortgage. APR (annual percentage rate) is the percentage of interest you will pay. A point equals 1% of the amount of the loan. Sometimes called origination points by the lender. Fees are the costs the lender charges to cover the expenses of making the loan. One lender may offer very low interest rates, but is making up for it in the closing costs, points and fees. Another lender may have a rate that s a little higher, but the closing costs are lower. Each lender must provide you with a Good Faith Estimate (GFE) (See an example on Page 7.) of the expected closing costs within three days of submission of the loan application. Compare these terms carefully. Let s say you have applied for a loan with two different lenders. To determine the true cost of your home equity loan, compare the items on the two GFEs. You can ask for an amortization schedule 2 of the loan, or do one yourself online using a mortgage calculator (www.bankrate.com has a good one) or with software that s right on your computer. Add the closing costs to the amount of your loan to arrive at the amount financed. 2 amortization schedule a detailed table showing the beginning principal amount of the loan, a breakdown by interest and principal for each payment and the ending balance. Page 4 of 8
Section 3: Look out for deceptive practices Some lenders target the elderly, people with low incomes and people with bad credit. Then they use deceptive practices including: Equity stripping Loan flipping Hiding the terms of the loan Packing a loan with extra charges Deceptive loan servicing Hidden home improvement loan Always consult a knowledgeable, trust-worthy family member, friend or financial advisor before making important financial decisions. Here s how these scams work. Equity stripping A lender encourages you to get a home equity loan even though you know your monthly income isn t enough to take on more debt. You may even be encouraged to pad your income on the loan application so you can qualify. Lenders like this are hoping you won t be able to keep up, because they have their eyes on your equity. When you default, they foreclose, taking your home and stripping you of the equity that s taken you years to build. Loan flipping This is when a lender encourages you to repeatedly refinance your loan and borrow more money, using your equity to get extra cash. It begins with a small loan to take a special vacation, for example. When the lender comes along again in a few months and encourages you to finance an even greater amount, you accept, thinking about how nice it was to have extra cash. Each time you refinance with the lender, you incur more fees, high points and your interest rate has most likely gone up. With each flip of the loan, you ve increased your debt. If you get in over your head, you could lose your home. Balloon payments Sometimes a lender will offer you an attractive, low-payment loan with a balloon payment after a couple of years. But you may be paying only interest during this time. At the end of the pre-determined payment period, you ll find that you have not reduced the principal at all. You will then be forced to either pay off the loan or refinance it. This adds up to more fees and probably a higher interest rate. Credit insurance packing One of the ways deceptive lenders pack your loan is by including charges at closing that have not been discussed as part of the deal. They hope you won t notice they ve added credit insurance or other benefits that you didn t ask for, don t want and probably don t need. If you do ask, they may tell you it comes with the loan, leading you to believe there s no extra cost. If you protest, the lender may use scare tactics telling you the deal will have to be rewritten or that your application will have to be reconsidered. So you sign, agreeing to buy additional products you don t want or need. Deceptive loan servicing The lender fails to provide accurate or complete account statements and payoff figures. It s hard to determine what you ve paid and what you still owe. Or they might send you letters saying your payments will be higher than expected for taxes and insurance you ve already arranged to pay yourself. Late fees might be assessed when payments are made on time. There may be legal fees you don t understand. Amid the confusion, you may pay more than you owe. Page 5 of 8
Hidden home improvement loan A contractor tells you that he can arrange financing through a lender to put on a new roof or remodel your two bathrooms. He begins work. Later, he gives you the papers to sign from the lender. Unbeknownst to you, you have agreed to a home equity loan with high points, fees and interest. He may threaten to quit working on the project unless you sign. Section 4: Protecting yourself against unscrupulous lenders NEVER, EVER Agree to a home equity loan if you can't afford the monthly payments. Fold under pressure to sign documents. Sign documents you haven't read or that have blank spaces to be filled in after you have signed. Agree to a loan that has extra products you don't want to buy, such as credit insurance, or that includes terms that weren't there when you applied. Allow the promise of extra cash or lower monthly payments to cloud your judgment about whether the cost is worth it. ALWAYS Demand an explanation of any cost, term or condition you don't understand. Federal law is very clear about what information must be provided in writing when you apply for a loan and before you sign any agreement. Shop around if you want credit insurance. Buying it from a lender may not be a good deal. Keep meticulous records of what you have paid, billing statements and canceled checks. Challenge charges you think are inaccurate. Check contractors' references before having work done on your home, and get more than one estimate. Keep a copy of everything thing you sign. Be sure you are dealing with a reputable lender. You may want to check with your local Better Business Bureau, state licensing authority, chamber of commerce or a consumer protection agency. The chart on the next page demonstrates how even small, unnecessary fees can make a big difference on the bottom line. Page 6 of 8
Compare two loans Let s compare two examples. Loan 1 is the shark s version and Loan 2 is the version you might see at your local lending institution. Note that the APR is lower on Loan 1, but that the payments and final payout are higher. The difference is in the fees and add-ons. Loan Terms Loan 1 Loan 2 Amount of loan $25,000 $25,000 APR 5.4% (.054) 6.1% (.061) Term 15 years 15 years Payment frequency Monthly Monthly Fees Loan application fee $100 $0 Credit report fee $50 $0 Document preparation fees $389 $225 Inspections $450 $0 Home appraisal $200 $200 Origination fees $1,000 $0 Credit life insurance* $650 $0 Total fees $2,839 $425 Amount financed $27,839 $25,425 Payment amount $226 $212 Total of all payments $40,679 $38,867 * Credit life insurance is sold as a one-time premium that is rolled back into the amount financed. It is NOT a good deal. Buy term life insurance from an insurance agent instead. Page 7 of 8
Lender: Address: Home Equity Loan Good Faith Estimate Note: This Good Faith Estimate is an example only. Your own Good Faith Estimate may look different. City State ZIP: Applicant(s) Name: Address: City State ZIP: Property Address: Sales Price: Items Payable in Connection with Loan Origination Fee % Discount Point Fee % Appraisal Fee Credit Report Mortgage Broker Fee Lender's Inspection Fee Underwriting Fee Base Loan Amount: Government Recording/Transfer Charges Recording Fees: Deed Recording Fees: Mortgage City/County Tax/Stamps: Deed City/County Tax/Stamps: Mortgage Additional Settlement Charges Processing Fee Survey to Courier Fee Wire Transfer Fee Items Required by Lender to Be Paid in Advance Interest from to @ per day Mortgage Insurance Premium for mo. Hazard Insurance Premium for years Reserves Deposited with Lender Hazard Insurance mos.@ /mo Mortgage Insurance mos@ /mo City Property Taxes mos@ /mo County Property Taxes mos@ /mo Total Estimated Monthly Payment Principal and Interest Real Estate Taxes Hazard Insurance Mortgage Insurance TOTAL MONTHLY PAYMENT Pest inspection to Title Charges Settlement or closing fee to Abstract or title search to Title examination to Title insurance binder to Document preparation to Notary fees to Attorney fees to Title Insurance to to Total Estimated Closing Costs Total Estimated Prepaid Expenses Total Estimated Funds to Close Page 8 of 8